5 Ugly Myths About the S&P 500

The S&P 500 Index is in many ways the most important stock market measure we have.

After all, the landmark Dow Jones Industrial Average relies on just 30 companies, does not include Apple (NASDAQ:AAPL[1]) and tends to lean to toward older industries like materials.

But what do you really know about the S&P 500? There is a lot of investor misunderstanding about this stock market index and how it is calculated. And some of these mistakes in perception could end up costing people real money in their portfolios if they aren’t careful.

Here are five ugly myths about the S&P 500 Index:

Myth #1: Composition

Myth: The S&P 500 is a list of the 500 largest companies in America.
The Truth: It’s actually hand-picked.

While the S&P 500 is comprised of large-cap companies, it is not as simple as sorting a list for the largest 500 companies. That kind of ranking would be difficult to follow as an index, since it would always change based on the performance and growth of individual companies. Also, a list of big dogs wouldn’t necessarily mean much for the broader market if the list was focused in just one place.

As such, the companies comprising the S&P 500 are selected by the S&P Index Committee. This group of economists, analysts and market-watchers picks big stocks that matter, but also makes sure that, collectively, the listing of 500 companies makes sense as a group. (Interested parties can read all about the methodology here.[2])

Myth #2: Representation

Myth: The S&P 500 is a measure of America’s economy and U.S. stocks.The Truth: The reach of multinationals gives it a distinct global flavor.

It’s true that in the early 1990s, the S&P Index Committee decided that only U.S.-domiciled companies would be included in the index. But the largest constituents got so big because of global growth. There’s Exxon Mobil (NYSE:XOM[3]) that drills and sells oil all over the world. There’s General Electric (NYSE:GE[4]), which gets more than half of its revenue from overseas.

You get the picture.

While America is, of course, a big factor here, do not make the mistake of thinking you have no international exposure if you invest in an S&P indexed fund like the SPDR S&P 500 ETF (NYSE:SPY[5]).

Myth #3: Diversification

Here’s a dose of reality for you: Apple represents almost 5% of the entire S&P 500. Exxon Mobil is another 3%.

That’s because the S&P is market cap-weighted — meaning bigger companies have bigger pull. Right now, the index is “worth” $12.7 trillion or so — and Apple’s $630 billion value and Exxon’s $400 billion value take up a lot of room in that equation.

Check out the current breakdown on the S&P website[6] about what each sector is weighted at right now. You might be surprised that both Exxon and Apple have more pull individually than the entire market cap of constituent telecom stocks or utility stocks!

So much for not making sector bets and being diversified …

Myth #4: Risk Reduction

Yes, an S&P 500 index fund like the SPY is diversified in regards to large-cap equities. But aside from the previous point of sector weighting, it’s important to understand there are whole segments of the market that don’t get included here.

While there is a global flavor via multinationals, the lack of foreign-based companies is one blind spot. And by definition, the large-cap index omits smaller companies with bigger growth potential and faster snap-back in a recovery. Also, REITs — a huge dividend-generating sector — don’t play into the S&P at all.

And if you really want to get technical, a fully diversified portfolio should include bonds, and many investors also advocate exposure to commodities or other physical investments like real estate. So the S&P 500 is not a one-stop shop.

Myth #5: Fund Costs

Yes, many S&P 500 Index funds do have low expense ratios. And you might think that it’s academic to shop around. After all, the SPY ETF isn’t that much more “expensive” with a 0.1% cost vs. the Vanguard S&P 500 ETF (NYSE:VOO[7]) and its 0.05% cost. And the Vanguard 500 Index (MUTF:VFINX[8]) mutual fund’s 0.17% expense ratio is hardly breaking the bank, even if the Spartan 500 Index (MUTF:FUSEX[9]) fund is lower at just 0.07%.

But guess what? There are some greedy funds out there.

The DWS S&P 500 Index C (MUTF:SXPCX[10]) fund, for example, has an expense ratio of 1.4%. And it’s not even a no-load fund! So read the fine print, especially for front loads or deferred loads that can hurt your performance.

Because of these expense ratios, performance is naturally affected. But other trading costs also factor in. After all, you can’t “buy” the S&P — you still have to rely on a manager buying individual component stocks. There’s no guesswork since the fund must follow the rigid rules of the indexing committee, but remember: There is real trading going on here in real stocks.

As such, you’ll see some index funds might underperform (or even outperform) the S&P 500 based on the particulars of how they buy and sell component stocks. Consider that while the actual S&P 500 is up 15.1% in the past 12 months (as of Friday’s close), the Vanguard ETF is up 15.5%, the iShares S&P 500 ETF (NYSE:IVV[11]) is up 15.1% and the Vanguard VFINX mutual fund is up 14.9%. That’s a range of 0.6 percentage points.

You might not think that’s substantial, but compounded over decades, that kind of difference adds up.

Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.”[12] Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

Interested parties can read all about the methodology here.: http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldata&blobtable=MungoBlobs&blobheadervalue2=inline%3B+filename%3Dmethodology-sp-us-indices.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=content-type&blobwhere=1244125623286&blobheadervalue3=UTF-8